The tech stock valuation battle behind Bill Ackman's billion-dollar Netflix bet

For a company that had seen shares rise 600-fold in less than 20 years, Netflix has always had its share of doubters. After its Jan. 20 report that it had slightly missed Wall Street targets for subscriber growth, those doubters pushed shares to less than half of their highs last fall, betting that the time has finally come when the video-streaming giant runs out of hypergrowth.

Now a $1 billion investment from hedge-fund titan Bill Ackman puts the question in stark relief: Should Netflix be a value stock now, with the company adapting to slowing growth by spending less and watching profit margins? And if it is, can it be a good one?

"If you think there are only 300 million potential streaming subscribers in the world, you should cut spending, raise prices and capitalize on the network you have," LightShed Partners media analyst Rich Greenfield said. "But there are huge pockets of growth out there over the next five years."

Almost no one on Wall Street has been a bigger bull, for longer, on Netflix than Mark Mahaney. The Evercore ISI Internet analyst had a buy on the company for more than a decade, usually predicting big gains no matter how expensive the stock seemed to others.

But Mahaney cut his recommendation after fourth quarter earnings, which coupled a slight miss on the company's forecast for subscriber growth with a prediction of a bigger slowdown in 2022's first quarter. 

"There's a reasonable chance that within five years they're growing 10% a year – 5% in new subscribers and 5% from price growth," Mahaney said. "I think there's a 50% chance they do that." 

Netflix doesn't see it that way, of course. In a Jan. 20 conference call with analysts, the company argued that the slip in subscriber growth is likely to be temporary, caused partly by the arrival of its biggest new productions – including a second season of the Bridgerton costume drama – late in the quarter, too late to let the company match its past pace.

There is "no structural change in the business we can see," Netflix chief financial officer Spencer Neumann said. "Retention was strong. Viewing was up. But on the margin, we just didn't grow acquisition quite as fast as we would have liked to see." 

So, the question becomes, what would Netflix look like if the company remade itself to focus on near-term profits more than growth? And how would that be different than a growth-model Netflix?

The company's strategy has emphasized growth and reinvestment in its product, especially pouring money into new films and shows. Sales have climbed to $29.7 billion last year from $6.77 billion as recently as 2015. The company spent heavily on new content, and didn't repurchase any shares in the fourth quarter, a move slower-growing companies emphasize to boost earnings per share by reducing share counts. Netflix also doesn't pay a dividend. 

First, a Netflix remade as a mature company would likely boost revenue around 10% a year, rather than the 19% it posted in 2021 or the 28% it grew in 2019, before the Covid pandemic, Mahaney says. His revised model for Netflix has the company's sales reaching $46 billion in 2025, up from just under $30 billion in 2021 – a 16% average growth rate that slows to 10.6% in 2025.

Second, it would likely continue to raise prices, as it just did in the U.S. market, by far its largest, when it raised most subscribers' prices by $1.50 a month to $15.49.

Third, it would be likely to slow growth in content spending, rather than curtail it. That would mean Netflix remains a giant force in determining what gets made in Hollywood. For comparison, its $5-plus billion in new content spending last year dwarfs the $1 billion spent by Viacom on content for its Paramount Plus streaming network. Media consulting firm Kagan Research has that number nearing $10 billion at Netflix by 2025, nearly matching what the company spends for all the other content it licenses from other producers.

Fourth, it would reduce Netflix's $15.5 billion in debt – a goal the company itself has endorsed. The company says it will pay down $700 million of debt this quarter. It's aiming for a long-run debt level of $10 billion to $15 billion – about twice the $6.19 billion in operating income the company made last year.

And it would mean the company embracing more stock buybacks, Mahaney said – another move the company itself is moving toward, if more gingerly than a business whose leaders are remaking its shares as a value play. The company said it will use an unspecified amount of excess cash to buy stock – a change from a history in which it has bought  almost none of its own shares before mid-2021.

It might not be a bad business, Mahaney says. Containing costs and building scale will let profits grow 21% a year, he says. "10% growth is still good," he said. "There's just a law of large numbers. Google will one day grow 10%. So will Facebook. It's just about how long it takes." 

Would all that be a better business than what Netflix has been doing, one likelier to move back toward the $690.31 a share stock peak it reached in October?

Greenfield says no.

The first point Greenfield  makes – one Mahaney also notes – is that the fourth quarter was hardly the first time Netflix has missed forecasts for subscriber growth. It has happened seven times in the last 20 quarters, and been outstripped by the 13 times Netflix has topped forecasts, according to the company's letter to shareholders announcing fourth-quarter results.

Like the company itself, Greenfield says Netflix is nowhere near exhausting its base of potential users. Its 75.2 million U.S. subscribers are less than three-fourths of U.S households, and the real pool of growth is overseas, he says. Netflix has only signed up about half of European households with high-speed Internet access, and about 15% of Asian homes, Greenfield said. 

There is also little sign that rising competition is denting Netflix much, in Greenfield's view. Recent Comscore data for the U.S. says Netflix commands 26% of all minutes consumers spend on Web video – topping the 21% for YouTube and single-digit numbers for streaming rivals like Hulu, Disney + and HBOMax.  

The most important reason why Netflix's share of minutes is holding steady is that it adds more new stuff to watch than rivals do, the product of all that spending on content. That's a reason to keep pushing, Greenfield says.

"If people watch more of your content, it's easier to raise your price," he said. 

The question Netflix has to answer is whether it's the next eBay or the next Google, according to Mahaney. Ebay reached the limit of its initial market for online auctions in the mid-2000s, after being one of the biggest Street darlings during the dot-com boom. The result: annual sales growth turned negative after the 2008 financial crisis and ran in the mid-single digits by the middle of the 2010s. Its shares stagnated for a decade, despite ill-fated acquisitions of Skype and PayPal, which were later sold off. Google has had a nearly unprecedented growth streak, by comparison.

In either model, Ackman has an excellent chance to build on his track record of high-profile scores – not least because Netflix, whose stock rose nearly 40% annually for 19 years after its 2002 initial public offering, had seen its stock fall to about 30 times this year's expected price – extremely modest by Netflix standards. 

Mahaney's model still gives Netflix a chance to boost profits to almost $140 a share by 2030 – way above the $14.10 per share it made in 2021. That requires the company to widen profit margins to 45%, from 21% last year. He says net profit margins should reach 30% by 2025. In the other scenario, Netflix keeps growing revenue by 15-20% a year, keeping up with content spending as Greenfield envisions.

Ackman seems to be counting on a little bit of both. In announcing his new stake, he emphasized his long standing respect for co-CEO Reed Hastings, the architect of the company's foot-on-the-gas strategy, and said he sees Netflix having "an improving free cash flow profile which should allow for continued investments in growth as well as the return of cash to shareholders."  

"Many of our best investments have emerged when other investors whose time horizons are short term, discard great companies at prices that look extraordinarily attractive when one has a long-term horizon," Ackman said in a letter to investors in his company,  Pershing Square Capital Management.